An Empirical Analysis of Valuation Algorithms for Pricing Callable Snowball Floaters

28 Pages Posted: 17 Aug 2009

See all articles by Damir Filipović

Damir Filipović

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Nils Friewald

Norwegian School of Economics (NHH); Centre for Economic Policy Research (CEPR)

Stefan Pichler

WU - Vienna University of Economics and Business - Department of Finance, Accounting and Statistics; VGSF (Vienna Graduate School of Finance)

Date Written: August 17, 2009

Abstract

In this paper we value a callable snowball floater, a complex interest rate instrument with variable coupon payments, which depend on the prevailing interest rates in arrears and recursively on previous coupon payments. The embedded option requires solving an optimal stopping problem using the dynamic programming principle. A well-known and widely used algorithm to estimate conditional expectations is a specific form of least squares Monte Carlo simulation introduced by Longstaff and Schwartz (2001), which we refer to as the LSM approach. Contrary to the standard approach, where discounted option values of the subsequent period are regressed on the current state variables, Longstaff and Schwartz (2001) use the ex post realized payoffs of in-the-money option scenarios from continuation instead. They argue that, in doing so, they get values less than or equal to the value implied by the optimal stopping rule, which provides an objective convergence criterion.

We compare the LSM approach with the standard approach and use the price estimate from an elaborate nested Monte Carlo simulation as a benchmark. We empirically find that the LSM estimate of the embedded option might be considerably downward biased, whereas the standard estimate is much closer to the benchmark price. Moreover, we find that there is no optimal type of basis function that can generally be recommended for pricing interest rate instruments. Instead, we suggest using the LSM approach to determine the optimal type of basis function that results in the largest option value and rely on the standard approach to price the instrument. These are important issues to consider when pricing complex interest rate instruments, in general, and callable snowball floaters, in particular.

Keywords: snowball floater, bermudan option, least squares Monte Carlo, nested Monte Carlo simulation

JEL Classification: C15, G12, G13

Suggested Citation

Filipovic, Damir and Friewald, Nils and Pichler, Stefan, An Empirical Analysis of Valuation Algorithms for Pricing Callable Snowball Floaters (August 17, 2009). 22nd Australasian Finance and Banking Conference 2009. Available at SSRN: https://ssrn.com/abstract=1456343 or http://dx.doi.org/10.2139/ssrn.1456343

Damir Filipovic

Ecole Polytechnique Fédérale de Lausanne ( email )

Odyssea
Station 5
Lausanne, 1015
Switzerland

HOME PAGE: http://people.epfl.ch/damir.filipovic

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Nils Friewald (Contact Author)

Norwegian School of Economics (NHH) ( email )

Helleveien 30
Bergen, NO-5045
Norway

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Stefan Pichler

WU - Vienna University of Economics and Business - Department of Finance, Accounting and Statistics ( email )

Heiligenstaedter Strasse 46-48
Wien 1190
Austria

VGSF (Vienna Graduate School of Finance) ( email )

Heiligenstaedter Strasse 46-48
Vienna, 1190
Austria

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